With Russia’s regulatory and settlement infrastructure on the mend, foreign fund managers appear to be slowly forgiving the market’s past indiscretions and giving Moscow its long-awaited international stature.
Granted, Russia has a long way to go before it can match the likes of its more established peers across the globe. Settlement delays, stolen securities, uncertainty over the status of a national securities depository, counterparty risk and poor governance procedures are just a few shortcomings fresh in many memories. Yet a number of advances, including the legal recognition of the National Settlement Depository (NSD), changes in the settlement process, and the NSD’s links launched in February 2013 with international securities depositories Euroclear and Clearstream have started to thaw a longstanding chill.
“Foreign fund managers weren’t clear whether they really owned shares in Russian equities and bonds and when they would receive their cash or securities,” says Stephan Pouyat, director of global reach product management for international securities depository Euroclear Bank. The result: investing in American Depositary Receipts (ADRs) of Russian companies became the norm as settlement occurs in US dollars on a three-day delivery-versus payment timetable through the US Depository Trust & Clearing Corp.
Rule 17f7 of the US Investment Company Act of 1940 calls for domestic registered mutual funds safekeeping assets abroad to rely on a legally acknowledged national settlement depository, but with multiple Russian organizations historically laying claim to that designation, US fund managers were hard-pressed to invest in the market. “It was the wild west and Russia turned into a high-risk market for more than just economic reasons,” one US fund manager tells FinOps Report. “In evaluating country risk, we had to take into account the lack of compliance with US regulations.”
NSD’s Recognition
The NSD, created through the merger of rival depositories NDC and Micex Settlement House in November 2010, finally won such accreditation from Russia’s securities watchdog the Federal Financial Markets Service, now called the Bank of Russia Financial Markets Service, in November 2012. Subsequently taking over the investment accounts held at local registrars scattered across Russia, the NSD has increased the total value of assets held in custody to RUB21.8 trillion from only RUB9.5 trillion in November 2012. Foreign investors no longer have to rely on Russia’s shareholder recordkeepers to change ownership of the most liquid equity shares on their books — a process which could take several days or even weeks to finish; instead trades will be settled on the books of the NSD in a delivery-versus settlement approach.
The NSD’s new legal recognition has also paved the way for its acceptance of foreign nominee accounts, thereby allowing members of Euroclear and Clearstream far easier access to the market. Prior to their year-old link with Russia’s securities depository, Euroclear and Clearstream did settle transactions in Russian government bonds, commonly known as MinFins. However, those were US dollar-denominated instruments that were phased out in 2011.
“We have developed and become more competitive — well-prepared for new investors and integrated with global financial infrastructures,” says Eddie Astanin, chairman of the NSD’s board of directors in summarizing the NSD’s initiatives. “As international investors gained access to the Russian markets and volumes in both on-exchange and off-exchange transactions increased, the local market has become more liquid and attractive.”
Also on the NSD’s agenda: to become a liquidity hub by establishing bilateral links with nearby central securities depositories in the former Soviet republics. “For international investors, the scenario provides an easier way to reach regional central securities depositories and their financial markets via single entry point,” says Astanin, referring to the NSD’s current connections with depositories in the Ukraine, Kazakhstan and Belarus. “It will also be easier and cheaper for CIS investors to reach other international markets for which we know there is a growing interest.”
Although 99 percent owned by the Moscow Exchange, the NSD has given local custodians plenty of say in how it is run. “We operate the NSD under a special agreement in which the largest participants hold one voting share each and over 50 percent of those shares must agree on significant decisions, such as changing tariffs,” explains Mikhail Bratanov, regional head of Russia for Societe Generale Securities Services (SGSS) which entered the market through its parent bank’s 2008 takeover of Rosbank. SGSS is a former NSD board member while Sberbank, VTB, Gazprombank, Citibank, Unicredit and JP Morgan are currently represented.
Euroclear and Clearstream’s operating connections with the NSD allow foreign investors to either settle their trades in Russian government bonds directly on the books of either depository or to rely on local custodian banks to settle their trades on the books of the NSD. Pending changes to Russian regulations, Russian equities are expected to be added to the mix in July 2014.
The consensus from five large European fund managers polled by FinOps: “Russia may not be as advanced as other markets but is making great strides, so our trustees are more receptive to investing in the market,” an investment officer for a European fund shop says. However, US fund managers appear a a bit more reticent in making the leap. “We are probably going to wait for another year to see how the market infrastructure pans out,” counters an investment officer at a US fund management shop.
Turf Battle
For their part, local custodians and broker-dealers in Russia aren’t exactly keen on the entrance of the international securities depositories into their cross-border business. Although Euroclear and Clearstream are eager to downplay any rivalry with local custodians, options create competition. “We have been instrumental in helping the NSD establish regulatory recognition and changing local legislation to ensure the acceptance of foreign nominee accounts at the NSD,” explains Pouyat, noting that there will be more business to go around. “In doing so, we are also helping increase business for local custodians as well.”
Mark Bosquet, head of network management for domestic markets at Clearstream, cites to the need for a “local account operator” a designation which falls short of full-fledged custodian services. Clearstream relies on Deutsche Bank as a middleman to reformat settlement and other messages to the NSD from the ISO 15022-compliant message formats to the depository’s proprietary electronic data interchange formats and vis-versa.
“Local custodian banks won’t be eliminated from the picture entirely, although they will have a diminished role,” says Bosquet. He concedes that local custodians — such as Deutsche Bank in Russia, used by Clearstream — will likely earn far less revenues than before. Euroclear referred questions about its Russian account operator VTB to the bank, which did not respond to requests for comment at press time.
Although there are no hard numbers for the percentage impact of foreign investment on the total number or value of trades executed either on the Moscow Exchange or over-the-counter, it’s clearly a sizeable dent in the Russian government bond market, accounting for an estimated 25 percent of float according to the Central Bank of the Russian Federation. After regulatory changes allowing bonds to be exchange traded, the Moscow Exchange acquired the bulk of trading volume as opposed to over the counter. Euroclear claims that since its service for Russian government bonds called OFZs was launched last year, the exchange has experienced a significant increase in trading volume in those securities.
Astanin notes that foreign investors still favor trading equities over-the-counter despite the Moscow Exchange lengthening its settlement timetable to two days from trading date (T+0) in September 2013, which allows for more flexibility in funding. Such a preference could spell more business for Euroclear and Clearstream over local custodians, say foreign fund managers.
The T+2 timetable, created for over two hundred of Russia’s most liquid equities as well as for Russian government bonds, eliminates the need for foreign investors to pre-fund the entire cash value of their transaction before settlement as was the case with the previous T+0 timetable. In addition, the financial instruments were not available for onward delivery to meet new settlement obligations until the following day. Still, pre-funding of a percentage of the value of the account remains the norm for Russian equities and bonds even under the T+2 schedule.
By contrast, Euroclear and Clearstream rely on a delivery-versus payment system, eliminating the need to prefund any accounts and allow counterparties to decide their settlement timeframe. That has typically come to a T+2 schedule for Russian government bonds and will amount to T+3 period for Russian equities.
Custodians Hopeful
Custodians won’t admit whether or not they have lost any settlement business in Russian government bonds to Euroclear or Clearstream, but Russian broker dealers say they suspect such is the case, since the two international depositories are easily eating into brokerage market share by more than 10 percent cent.
Nevertheless, local banks are hopeful they will have an upper hand when it comes to settling equities. “It is difficult to predict the impact ICDs will have on our business, but a few facts should be taken into account,” says Bratanov. “We need to remember that Euroclear and Clearstream specialize in settling fixed-income instruments. In addition, Russian regulation prevents local players from holding domestic assets at the ICSD level. Therefore, such players will require local custodians.”
Also helping local custodians shore up relationships with foreign investor clients, predicts Jean-Louis Bernardo, deputy head of SGSS in Russia, is the new legal designation of tax agent. Such a status, effective this month, requires custodians to collect the correct amount of withholding tax from foreign investors, who must ultimately must be identified to Russia’s tax authority.
Naturally, the devil is in the documentation which must be meticulously gathered and local custodians suggest that holding assets through ICSDs makes compliance far more difficult. “Foreign players may be puzzled by the complexity of such new requirements, especially in connection with recently structured foreign nominee and foreign account holder schemes,” says Bernardo. “Despite the legal liability to be assumed by local custodians vis-à-vis local tax authorities, this new legal framework provides an opportunity for local players to strengthen their privileged relationships with foreign clients.”
Establishing more efficient post-trade procedures aside, Russia is also in dire need of improvement in corporate governance practices, foreign fund managers tell FinOps Report. Not only is voting cast through paper-ballots, but there is no standard timetable by which Russian corporations disclose annual agendas or set timetables for voting. Even worse, large family ownership of public firms, the lack of an independent board of directors and ignoring the rights of minority shareholders are still common practices, giving Russia a poor scorecard from international shareholder activists.
“The efforts of the Russian government and leading corporations to improve the quality of corporate governance through the adoption of the Russian Corporate Governance Code and the NSD’s efforts to standardize dissemination of information on corporate actions are certainly areas of improvement in the coming years,” says an optimistic Bratanov.
The corporate governance code — a voluntary set of guidelines adopted by Russian public companies last year — calls for independent governance boards, more public ownership, and improved financial disclosure. The NSD, which publishes information on corporate actions on its website, recently tapped enterprise-wide data management software firm GoldenSource to help ensure the accuracy of such information and distribute it through ISO 15022-compliant message types this year.